How To Really Measure a Company’s Innovation Prowess

Who is the world’s most innovative company? The editors of Fast Company say Nike. Last year, number crunchers at Forbes found that Salesforce.com is the company with the highest “Innovation Premium” baked into its stock price. MIT Technology Reviewdidn’t pick a winner, but on its recent list of top 50 “disruptors,” the magazine mixed stalwarts such as General Electric and IBM with up-and-comers, Square and Coursera.

The difference of opinion isn’t a new thing — in fact, if you look back a few years at similar lists you’ll see less than 50% overlap. Why? Perhaps a company’s ability to innovate doesn’t last long. Or perhaps it is difficult to really tell how well a company’s innovation engine is functioning — so magazine editors are susceptible to the latest hot product or service.

There’s no doubt: measuring “innovation” is a fuzzy business. Part of the problem is there isn’t a clear consensus on what marks an innovative company. But there are some measurements that try.

Since the primary purpose of innovation for private companies is financial impact, ” Return on Innovation Investment (ROII) is a reasonable, aggregate measuring stick for innovation — you can calculate ROII by taking the profits or cash flows produced by innovation and dividing that figure by the cumulative investment required to create those returns. Conceivably, this ratio could look backwards (measuring the actual results of historical investment) or forward (measuring the expected value of current investments in innovation).

While ROII can be of some utility, it doesn’t precisely measure how a company achieved a particular result. That’s where the Dupont analysis come in.

In the 1920s, while companies used return on equity to assess their performance, DuPont recognized that the single metric had its limits. So it began disaggregating return on equity into three components.

Return on equity (net income divided by equity) results from multiplying three key operating ratios:

Profitability (net income over sales)

Operating efficiency (sales over assets)

Financial leverage (assets over equity)

This simple formula provides rich insight into a company’s business model, and can quickly diagnose a company’s strengths or opportunity areas.

With Dupont in mind, we can come up with a better measurement by sub-dividing ROII as follows:

This split would highlight different innovation strategies available to companies. Companies that played it relatively safe could have a high success rate, low magnitude, and high efficiency. A company could achieve the same returns by compensating for lower success rates with higher efficiency or magnitude.

This kind of breakdown would be valuable for both leaders and investment analysts who want to assess a company’s innovation capacity. It might even turn out that this framing highlights a few archetypical strategies that are more (or less) appropriate for different corporate circumstances.

One challenge today is that few companies have these numbers at their fingertips, and the lack of common definitions and publicly available statistics makes benchmarking difficult. Simple questions, like “what defines an idea?” or “what does ‘success’ mean?” need to be answered in consistent ways.

Given how critical innovation is for a company’s long-term success (and sometimes survival), perhaps it is time to mandate that publicly traded companies regularly report on their innovation pipeline and the key drivers of their innovation performance.

Until they do, at least be wary of the next company that graces a magazine cover. After all, half of the top 20 companies traded on U.S. equity markets* on BusinessWeek’s 2008 list ended up underperforming broader market indices between March 2008 and March 2013. While strong performance by Amazon.com and Apple meant an investment in those 20 companies beat an investment in the S&P 500, Blackberry (see Research in Motion), General Motors, Nokia, Sony, and Toyota certainly have had their share of difficulties over that time period.

* The top 23 also included India’s Tata Group and Reliance Industries and Germany’s BMW.